While filing income tax returns, the dullest yet most crucial factor is AGI. If you do not understand what adjusted gross income (AGI) is, you might end up paying more taxes than you should. Don’t worry; we have gotten you covered! Read more to know about what it is and how to calculate AGI.
While filing your income taxes, one of the first steps in filing income taxes is calculating your adjusted gross income (AGI), which determines your taxable income for the relevant year. The determination of your tax liability for the year depends on the adjusted gross income calculation. Your AGI plays a crucial role in determining which tax credits or deductions you may qualify to claim on your tax return. Usually, if your AGI is too high, you will not be eligible for tax write-offs such as student loan interest deduction, education credits, and certain definite deductions. Your AGI determines your tax bracket and how much you will pay in income taxes.
If you file your taxes online, the tax software program you use will probably figure out your AGI for you. However, it is helpful to understand how to calculate AGI and its relationship with certain tax benefits. Michele Cagan, the certified public accountant, said, “The reason it matters is that a lot of deductions, tax credits, whether or not you can contribute to certain retirement accounts depends on your AGI. The lower AGI means you will pay the lower tax bill.
If you prepare your taxes, you must be well equipped with every tool, required data, and information you need to know about adjusted gross income. As the name indicates, AGI deducts some adjustments from gross income. The AGI derives from gross income, which includes any financial earnings accrued during the fiscal year, such as capital gains, retirement distributions, business income, dividends, and other sources of income within legal boundaries.
So, are you ready to know more about AGI, its calculation, and its importance in your taxable income? Let’s start!
Table of Contents
- 1 What is adjusted gross income
- 2 Calculation of AGI
- 3 How AGI is used to calculate taxes
- 4 How your adjusted gross income affects your taxes?
- 5 What can I do to lower my AGI?
- 6 Adjusted gross income on 1040
- 7 Conclusion
What is adjusted gross income
International Revenue Services defines adjusted gross income (AGI) as gross income minus adjustments to income. Gross income includes your wages, dividends, capital gains, business income, retirement distributions as well as other income. In contrast, adjustments to income have items such as educator expenses, student loan interest, alimony payments, or contributions to a retirement account. It is further necessary to know that adjustments to your gross income refer to acceptable tax deductions. These deductions vary depending on your unique situation and are influenced by unexpected life events such as jury duty, new employment, or a pandemic. Your AGI will never be more than your Gross Income on your return though it can be lower in some cases.
Your AGI is another name for your tax liability in any given year. It measures how much income tax you owe to the government in a tax year. Therefore, adjusted gross income is usually more important than gross income.
Benefits of adjusted gross income (AGI)
Without the AGI, you might have to pay taxes on every cent of your gross income. When individual U.S. taxpayers and households use IRS form 1040 to calculate and file their yearly taxes, it is an absolute need to calculate AGI. AGI has several uses for a taxpayer. The most common benefits are to determine:
- How much of your income is taxable.
- Your tax bracket.
- You qualify for the credits and exemptions, including charitable deductions, deductions for adoption expenses, dependent tax credits, and earned income credit.
- The IRS makes deductions from your gross income to arrive at your AGI. The more deductions mean less taxable income and the lesser your taxes.
- The IRS uses AGI to prevent taxpayer fraud while submitting tax returns electronically. Therefore, when you e-file your federal tax return, you will need to digitally sign your AGI and verify your identity or set up a Personal Identification Number (PIN) for your verification.
Modified adjusted gross income (MAGI)
When you calculate your AGI, you may also need to figure out your modified adjusted gross income (MAGI). The modified gross adjusted income determines your eligibility for certain deductions/benefits as per IRS’ rules and regulations. The IRS uses the MAGI calculation to determine how much of an individual’s IRA contribution is deductible and whether an individual is eligible for premium tax credits. The higher the MAGI, the fewer deductions you can take on IRA contributions. If your MAGI is too high, IRA deductions can even reach zero. In this scenario, you can still contribute to an IRA plan; however, you cannot deduct any contributions from your taxes.
The IRS can use it to determine your eligibility for tax deductions to an individual retirement account (IRA). Certain education-related tax benefits and income tax deductions depend upon MAGI as well. For instance, according to the Affordable Care Act (ACA), your household MAGI also has an impact on whether you can get income-based Medicaid or subsidized health insurance through the Marketplace.
Calculation of AGI
How to calculate AGI is a query that every tax filer wants to answer. You will start with your gross income to determine your adjusted gross income. As discussed earlier, this includes wages or salary from a job, bank account interest, stock dividends, and rental property income. If you report self-employment business income on Schedule C (Schedule C is a tax form that some small business proprietors use to file their tax returns each year), you will also include that in your gross income. Bonuses, tips, alimony, and even gambling winnings are also part of gross income. Typically, you can not add life insurance payments, child support, loan proceeds, inheritances, or gifts to your AGI.
Once you calculate the aggregate amount of your gross income, you then subtract specific amounts by making “adjustments,” also known as “above the line” deductions, which are available to taxpayers even if they are taking the standard deduction.
An example of payment you may subtract from your gross income is a contribution to a qualified retirement account, such as an IRA. Other permissible subtractions may include interest on student loans, alimony payments, contributions to health savings accounts (HSAs), and certain kinds of moving expenses; after subtracting all of these adjustments from your simple manual formula to calculate adjusted gross income is:
All income – exclusions from income = gross income
Gross income – deductions for AGI = adjusted gross income
Several online tax preparation services and software programs calculate AGI for you and automatically enter it into the correct line. Regardless of these convenient features, make sure you enter these amounts correctly when transferring the information from the forms your employer gives you to Form 1040.
Available online calculators
Multiple tax software programs help systematically to calculate adjusted gross income. We have listed below the few popular tax software for you to calculate AGI:
- H & R Block
- Jackson Hewitt
How AGI is used to calculate taxes
You can use AGI to calculate your taxes in two ways:
- As you are now aware, it is the starting point for calculating your taxable income, which is the income you pay taxes. If applicable, subtract either the standard or itemized deductions and the qualified business income deduction from the adjusted gross income to determine taxable income.
- If your AGI is high, you become ineligible for certain tax deductions or credits. In taxation books, they call this phenomenon “AGI threshold.”
We have some examples of AGI thresholds for your understanding, which includes:
- You can generally deduct up to 50% of your adjusted gross income when making charitable contribution deductions.
- You can claim unreimbursed medical expenses if they are 7.5% or more of your AGI.
- Tax breaks for education, such as the American Opportunity Tax Credit, the Lifetime Learning Tax Credit, and the student loan interest deduction, either have specific limitations or get eliminated if your AGI is too high.
How your adjusted gross income affects your taxes?
Your AGI directly influences your eligibility to claim many of the deductions and credits available on your tax return. The earned-income credit and the child and dependent care credit depend on AGI calculations. Similarly, tax deductions, including mortgage insurance premiums and medical expense deduction thresholds, depending on your AGI as well. Adjusted gross income affects your taxes to the extent to which you can use deductions and credits to reduce your taxable income. For example, consider the effect of AGI on medical and dental expenses for taxpayers who itemize.
Those who itemize can deduct only qualified medical and dental expenses, higher than a certain percentage of their adjusted gross income. For 2021, this limit was once again 7.5% of your AGI, which means if your medical and dental expenses did not exceed 7.5% of your AGI, you possibly would not be able to deduct them at all. So, let’s say if your adjusted gross income is $40,000, anything beyond the first $3,000 of medical bills or 7.5% of your AGI could be deductible.
AGI-related limits also apply to deductions for tuition and charitable contributions. You can generally deduct qualified charitable donations you made only until the deduction amount reaches 50% of your AGI. Therefore, your AGI has a significant effect on which deductions and credits you can take, as well as how much they’re worth.
Your adjusted gross income is significant if you live in a state that collects state income taxes. Many states use the AGI from your federal return as the starting point for state income tax calculations.
What can I do to lower my AGI?
There are several ways to lower your AGI. First, make sure you take advantage of the “above-the-line” deductions for which you qualify. If you work as an educator, performing artist, or reservist, make sure you understand the business expenses you can use to adjust your income and take advantage of them.
If you have student loans, you can slow down your repayment to decrease your AGI. It’s usually a good idea to pay off your student loans as fast as possible so you can hold on to more of your money for other financial goals. However, if you want to lower your AGI, the student loan interest is one of the appropriate ways to reduce it. When you take your time to pay off your student loans, more of your payment will have interest, and interest on students comes off as an above-the-line deduction, reducing your AGI.
Contribute to a traditional IRA, Simple IRA, or SEP-IRA, or increase your contributions to those accounts. Every dollar you add to one of these IRAs is subtracted directly from your gross income, reducing your tax liability. The same is valid for contributions to a health savings account (HSA). If you have an HSA-compatible health insurance plan, you can contribute to the HSA up to $3,500 for individual coverage or $7,000 for a family plan each year. And every penny you donate lowers your AGI.
If you sell stocks or other investments at a loss, that can reduce your AGI. You can claim a net capital loss of up to $3,000 each year. It is further necessary to know that if the employer sponsors a pre-tax retirement plan such as a 401(k), you can defer some of your income to that plan, and that income will not even show up on your tax return. This way, you can pull out your contribution amount before calculating gross income to reduce your AGI from the beginning.
Understanding adjusted gross income does not mean you comprehend an essential line on your tax return. It means you can actively work to reduce your AGI and lower your tax bill in the process.
Adjusted gross income on 1040
Form 1040 is the tax form you will need to use every year for your federal income taxes. Before the 2018 tax year, there were multiple versions of 1040, but for 2019 and beyond, the form consolidated into one version. People with more complicated tax situations may need more forms and schedules; however, everyone filing taxes will need to fill out 1040.
The full name the IRS gives to Form 1040 is “Form 1040: U.S. Individual Income Tax Return.” As of 2019, there is only one version of Form 1040, which means all tax filers must use it. Previously, filers with simple tax situations could use the 1040EZ or 1040A. However, these forms are no longer in use because of the tax plan that Ex-President Trump signed into law in late 2017. The only exception is Form 1040NR, which non-resident immigrants can use.
Below is the brief overview of four variations of the 1040 form (1040A and 1040EZ no longer exist):
- Form 1040: This is the one the majority of taxpayers will use to report income and determine their tax for the year and any refund or additional tax owed.
- Form 1040-SR: This version is for senior taxpayers (65 and older). Form 1040-SR is nearly identical to Form 1040 but is printed using a larger font and includes a chart for determining the taxpayer’s standard deduction.
- Form 1040-NR: This form is for non-U.S. citizens who do not hold a green card, and it is several pages longer than the other 1040 form versions.
- Form 1040-X: This form is for taxpayers who need to amend their tax return after filing a Form 1040.
There are two pages of 1040. The first page asks for your basic personal details, including your name, address, Social Security number (SSN), and filing status. If you’re filing jointly, you also need to add the name and SSN of your spouse.
Lines 1 through 7 on form 1040 are all about your income. If you have a W-2, you will need to enter the earnings information from that form in the form 1040. You also need to attach all W-2 forms you have. Afterward, you can enter information on any interest, dividends, pensions, annuities, individual retirement account (IRA) distributions, or Social Security benefits. When you write down your income, you will make all required and applicable adjustments to get AGI. Your AGI, as you are now aware of, is the federal government’s income figure to determine how much you owe in income tax.
You will report your AGI on line 11 of the tax year 2021 Form 1040. You can reduce it further with either the standard deduction or the total of your itemized deductions reported on Schedule A. Itemized deductions include expenses such as:
- Mortgage interest,
- State and local income taxes or sales taxes,
- Charitable contributions, and
- Excess medical expenses.
Taking these deductions will require you to attach additional forms to your return. Previously, 1040 included a 15-line section that took filers through a number of the available above-the-line deductions. However, since not all tax filers make adjustments, the IRS removed this section from the 1040 and spread it across Schedules 1 through 6. Hence, Form 1040 is the basic form for filing your federal income taxes.
The form walks you through calculating your AGI and claiming any credits or deductions for which you qualify. The form ends with helping you determine your refund or how much you owe. You can also use any online software to make your calculations easier.
What are the different schedules used with Form 1040?
Although Form 1040 is relatively short, there are various schedules, or additional forms, that help taxpayers calculate specific items that apply to Form 1040:
- Schedule 1: A tax filer will report several familiar additional income sources or adjustments to income. Common examples of items reported on Schedule 1 include alimony, gains or losses from the sale of business property, unemployment compensation, educator expenses, tuition, fees deductions, and health savings account contributions.
- Schedule 2: You can report additional taxes in this schedule, and it now consists of two parts. The first part is for reporting alternative minimum tax and repayments of excess premium tax credits for health insurance purchased through the health insurance marketplace. The second part serves the purpose of reporting self-employment taxes, unreported social security and Medicare tax, additional tax on IRAs or other tax-favored accounts, household employment taxes, repayment of first-time homebuyer credit, and section 965 net tax liability for foreign corporations.
- Schedule 3: This form is for reporting additional credits and payments, and it comes into two parts: refundable credits and non-refundable credits. Credits said here include credits for child and dependent care expenses, residential energy credits, overpayment of taxes in previous years, and previously paid excess social security taxes.
- Schedule A: This is a common form used to enter all itemized deductions, including medical and dental expenses, mortgage interest, state and local taxes, charitable donations, and casualty and theft losses.
- Schedule B: Taxpayers use this to report interest and dividend income higher than $1,500. If you have interest and dividend income under that amount, you will enter that directly on lines 2 and 3 of Form 1040.
- Schedule C: This form is for reporting profit or loss from business used by independent contractors, freelancers, and owners of sole proprietorships or single-member LLCs.
- Schedule D: You will report capital gains or losses from investments.
- Schedule E: Those who have income or losses from rental real estate, royalties, partnerships, S corporations, estates, trusts, REMICs, or other pass-through entities will report those amounts on this form.
- Schedule F: Farmers use this form to report income and expenses from farming.
- Schedule H: Taxpayers with household workers, such as a nanny or caretaker, use this form. Since the taxpayer is responsible for withholding income for social security and Medicare taxes, those will also report here.
- Schedule J: Those farmers and fishers use this form, who choose to figure their income tax by averaging their three previous years’ worth of taxes to more evenly distribute tax liability.
- Schedule R: This form claims the senior or disability tax credit.
- Schedule SE: Business owners or independent contractors who earned a profit of at least $400 use this form to calculate self-employment tax.
- 8812: This form is for claiming the additional child tax credit on your 2020 tax return. If the total child tax credit amount for all qualifying children in your household exceeds the amount of tax you owe for the year, then you will prepare this form to calculate the refundable portion of the credit.
Calculating your AGI is crucial to determining how taxable your income is. It can be relatively simple if you have a good idea of what parts of your income contribute to the figure. However, some of these situations can get tricky with changing tax laws and forms. If you are unaware of how to calculate AGI, the smart move would be to work with an accountant or use a reliable tax software program to help you out. Moreover, many financial advisors offer tax planning and tax preparation services.